States Start Shoring Up Rainy Day Funds

States are taking funds that could be used to avert cuts and instead putting them in the bank. Is that the right move?

The budget Rhode Island Gov. Lincoln Chafee signed earlier this year includes something for just about everybody to dislike: a bevy of new taxes and fees; $100 million in state spending cuts; increases in premiums for families using Medicaid; and a hiatus on new school construction.

Yet at the same time Rhode Island officials were also putting money into the state’s rainy day fund where, for at least the immediate future, it likely won’t be spent. The move may seem counterintuitive, but it's not unusual. As state lawmakers nationwide are making difficult decisions about what programs to cut, they’re simultaneously storing away millions of dollars that could be used to help ease the pain.

“There was zero debate about putting it back in,” says Jerry McDaniel, director of Florida Gov. Rick Scott's policy and budget office, referring the restoration of its rainy day fund. This fiscal year, Florida put $213 million back into its rainy day fund after pulling more than $1 billion from it in the 2009 fiscal year. It was the first time money’s been added to the fund since that withdrawal. “Everybody’s for it. Everybody’s in favor of it."

In the wake of the recession, more than 70 percent of states used their rainy day funds to help plug budget gaps, and some states completely exhausted those funds. Using those reserves helped reduce the need for big tax hikes and likely made spending cuts smaller than they would have otherwise been, according to the Center for Budget and Policy Priorities (CBPP).

Those actions reduced the value of state balances – which include both rainy day funds and other reserves – from $69 billion in FY 2006 to $31.5 billion in FY 2010, according to the National Association of State Budget Officers.

But now a growing number of states are shoring up their reserves and restoring the money they pulled out, even though the economy hasn't fully rebounded. While revenue for states has been improving, in many places, it’s still not back to its pre-recession peak. States collectively faced a $103 billion budget gap as they approached the current fiscal year, according to CBPP.

In some cases, the decision to pump money into reserves is largely out the control of state legislators, with constitutions and statutes governing when the money must be paid back and in what quantity. But in many cases, state lawmakers and budget officials are actively appropriating those funds, reasoning that as rough as the economy is right now, a double-dip recession could be worse -- and they want to be prepared.

“Having gone through this great recession, and these huge cuts, I think there’s a mindset of not knowing what’s coming,” says Scott Pattison, executive director NASBO. “If we have a double-dip, it makes them really uncomfortable to have rain day funds close to zero.”

States also pump up the funds to please ratings agencies, which want to see that states have a cushion in case of the unexpected. A downgrade would increase the cost of borrowing for states.

In a sense, making transfers to the rainy day fund is a gamble. If the economy worsens, states will indeed have reserves available to help mitigate cuts. But if the economy improves, they’ll have been storing away resources at a time when they may have been cutting programs and personnel unnecessarily.

For Rhode Island's leaders, the decision to put $22 million it borrowed two years ago back into the reserves was driven largely by the state’s existing laws. The state is only allowed to spend 97 percent of its revenue, with the rest going to the rainy day and capital funds. Another state law requires Rhode Island to quickly repay the money it borrows from the rainy day fund. And a constitutional amendment passed in 2006 – shortly before the recession – raised the minimum balance of the rainy day fund from 3 percent of the budget to 5 percent. “It happened when things were looking a little better,” says Thomas Mullaney, the state’s budget officer. “Then all of a sudden, you’re getting less revenue in, and you can spend less of it.”

As a result, the state has increased its reserves, even as it continues to make painful budget decisions.

Such moves are becoming more prevalent. Projections made by NASBO earlier this year, based on governors’ budget recommendations for the current fiscal year, showed 18 states on pace to increase their rainy day balances, compared to just 5 that would further deplete them. Another 27 were on pace to have an unchanged balance. At the same time, many of the same states building up their reserves were also cutting spending in a variety of areas. NASBO is currently compiling data based on enacted budgets.

This fiscal year, North Carolina legislators gave a $150 million infusion to their rainy day fund, bringing its total to nearly $300 million – the first time the fund has gotten money since 2007, said state budget director Andy Willis. State law requires a portion of the surplus to go to the fund, but a newly-elected conservative legislature went well beyond the requirement.

The move came in midst of steep layoffs of state workers, including more than 3,000 University of North Carolina system employees who lost their jobs due to cuts. Willis acknowledges that it can be difficult to explain layoffs when there’s being money added to the bank, but rainy day funds likely couldn’t have spared those jobs.

“Would that $150 million have eliminated our $2.6 billion in cuts?” Willis says. “Yeah –by $150 million. It’s very small, compared to what we had to do.”

With uncertainty facing the state – include the ever-present risk of a hurricane; a possible double-dip recession; and looming federal spending cuts – Willis says elected officials are planning for the worse, even if things already seem bad.

Meanwhile, voters across the country seem to be signaling support for building up reserves. A year ago, voters in four states – Hawaii, Oklahoma, South Carolina and Virginia –approved ballot measures that would expand rainy day funds. Next week, voters in Washington state will decide whether to put a larger portion of future surpluses into the rainy day fund during unusually bountiful times.

At the end of last fiscal year, Oklahoma was able to make a $249 million deposit into a rainy day fund that had previously been completely depleted. Oklahoma legislators didn’t make a special appropriation. The funds came as a result of state law that automatically sends a portion of the surplus into reserves, and those surpluses haven’t existed in recent years.

“The part that gets hard is coming out of budget cuts and still doing this,” says Brandy Manek, director of budget and policy for Oklahoma. But, she notes, the rainy day fund has helped the state weather difficult times in the past, so she’s glad the fund is being replenished.

"If we had not had these rainy day funds over the past two or three years, the furloughs and the cuts would have been much more severe,” Manek says. “We need to have that there in order to give us stability across those years.”

Not every state is taking that approach. Washington’s rainy day fund was created in 2007, just as the economy began its nosedive, and the fund has essentially remained perpetually empty. The funds it has are expected to be tapped yet again this budget cycle. “In these years, when we’ve been down, nobody’s complained about taking it out,” says Marty Brown, director of the state financial management office. “They know that’s what it’s there for.”

And some experts don't think it's prudent to shore up rainy day funds right now, since the recession is still affecting state revenue.

Elizabeth McNichol, a senior fellow at the Center for Budget and Policy Priorities, emphasizes the importance of building up reserves, but she also believes it's important that states use those reserves during hard times. A report by her colleagues found that there were seven states that entered this fiscal year with large reserves that they could have used to help lessen the size of spending cuts. Just two did so: Nebraska and Iowa.

The poster child for the debate is Texas, which faced an $18 billion shortfall as it approached the current two-year budget cycle but failed to tap its $6 billion in reserves. Residents there are now enduring deep cuts to education programs and health care in particular.

What may really be happening is fiscally conservative legislators trying to shrink government to what they view as a more sustainable size in the long-term. If that’s the case, then trying to mitigate those cuts with funds that could otherwise go in the bank would be counterproductive to their goals.

“If you’re making structural adjustments, and you have money left over it, you can put it in a rainy day fund,” says William Fox, director of the Center for Business and Economic Research at the University of Tennessee. “It’s not a bad plan.”

Still, Fox says states should establish detailed rules ahead of time that dictate, based on fiscal conditions, when they’ll shrink rainy day funds and when they’ll grow them. That way, these types of decisions don't have to be made annually.